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Key Points

Global growth has picked up meaningfully since its trough in early 2016, but the boost from stimulus is likely to fade a bit in 2017.

Central bank policy has become harder to predict now that growth has picked up and higher oil prices are likely to cause a bounce in headline inflation.

China’s political transition is likely to keep the fiscal spigots open, but other major emerging markets appear to be going through an orderly deleveraging process.

A populist wave in developed markets has further complicated the global outlook, increasing the possibility that growth is either much slower or faster than envisioned in our base-case scenario.

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The pace of global gross domestic product (GDP) growth has accelerated meaningfully since its trough in the spring of 2016. The improvement in the momentum of global growth has been relatively broad-based and has been driven by looser global financial conditions and the delayed impact of Chinese stimulus measures taken early in 2016. Additionally, growth has benefited from a slowing in the pace of inventory liquidation and the stabilization in commodity prices.

As the impact of stimulus in both China and the developed world fades in early 2017, we expect global growth to slow a bit from its peak in late 2016. The global economic outlook has also grown more uncertain due to the rising wave of populism in developed markets, which may lead to stronger growth through greater fiscal support in some regions, while threatening progress in others.

MONETARY OUTLOOK GROWS MORE CLOUDED AS GROWTH IMPROVES

As economic conditions have improved, uncertainty about the future stance of global monetary policy has increased. The assumption that the Fed will restrict itself to two or three interest rate increases in 2017 has been challenged by the prospect of increased

fiscal stimulus under the incoming Trump administration. A wave of stimulus accompanied the first years of the Obama, Bush II, and Reagan administrations, but, in each case, fiscal expansion came against a background of substantial slack in the U.S. economy. How inflation will respond to stimulus when the economy is near full employment is unclear, as is the Fed’s likely reaction.

Financial markets are also adjusting to the reality that the European Central Bank (ECB) has started to implement a less accommodative monetary policy stance. There is no evidence that core inflation in Europe is rising significantly, but rising energy prices mean that headline inflation is poised to bounce in early 2017. Additionally, the output gap is closing in Europe’s largest economy, Germany. As a consequence, longer-term inflation forecasts show headline inflation gradually rising toward 2% and provide the ECB with an argument to tiptoe toward a process of monetary normalization. As announced in the December meeting of the monetary policy committee, the process of normalization has taken the form of a slowing of the pace of quantitative easing (QE). The question about further tapering of the QE program is likely to provoke fierce debate among ECB policymakers.

Asian economies have a similarly indeterminate policy outlook. In September 2016, the Bank of Japan made a substantial change to its monetary program, announcing that it would adjust its QE purchases in order to target stable and positive longer-term yields. The new program remains unproven, but it may help the bank control the appreciation of the yen, which has weighed heavily on the Japanese economy.

Meanwhile, China is wrestling with rising corporate debt loads, especially for state-sponsored firms, and the need to manage an increasing stock of nonperforming loans in its banking system. The fiscal spigots that helped stabilize the economy early in 2016 are likely to remain open as the top leadership in the Politburo Standing Committee undergoes a transition. The other major emerging markets appear to be continuing to go through a relatively orderly deleveraging process as they digest the lending boom that developed on the back of the very loose monetary policy stance in the developed economies. How these economies fare will be an important determinant of overall global growth.

POPULIST WAVE IN DEVELOPED MARKETS FURTHER CLOUDS OUTLOOK

Late 2016 saw the headwinds of emerging market deleveraging—which have been evident to us for some time—joined by the crosswinds of developed market populism. Britain’s decision to leave the European Union (EU) and

Donald Trump’s election in the U.S. both reflected a broader pattern of disaffection among voters in developed economies, fed by widening inequality and a growing sense that the benefits of economic growth are not trickling down to the middle class. The uneven distribution of the wealth and income generated by globalization is pushing voters to search for new champions in candidates who promise to protect manufacturing jobs by curbing immigration and reversing the flow of imports from low-wage developing economies.

How far this populist wave will travel in 2017, particularly in Europe, remains unclear but could have major impacts on global growth. Although Austria’s far-right Freedom Party was unable to take the presidency in a runoff in early December 2016, electoral gains seem likely in 2017 for similar parties in France, Italy, Germany, Greece, and the Netherlands. While none of the anti-globalization parties are currently favored to win elections outright, recent history has shown that pollsters are seemingly ill-equipped to capture the intentions of frustrated voters. An uncertain political environment is likely to encourage corporate managers and investors to defer irreversible decisions, which will likely create an additional headwind to growth and capital formation in Europe.

Concerns have also deepened about the possibility of a so-called hard Brexit. Whether British Prime Minister Theresa May will be able to follow through with her promise to begin the formal process of withdrawal from the EU by the end of March is unclear, as the roles of the High Court and Parliament are still not fully settled. May and her political circle have sent conflicting signals over their willingness to sacrifice access to the customs union and the single European market in order to maintain control over immigration, and their position may evolve further.

A “hard Brexit” would have a widespread impact, but we would expect it to weigh most immediately and forcefully on the British pound. The Bank of England might respond with lower rates and an extension of its QE program in order to protect the economy—even as the weaker pound has raised inflationary pressures in the UK.

TRUMP’S ELECTION HOLDS BOTH PROMISE AND PERIL FOR ECONOMY

Populism in the U.S. is taking a different form and will have disparate effects on the U.S. economy. Central elements of Donald Trump’s economic plan include a pro-growth tax plan, a new modern regulatory framework, including an unleashed energy sector, and an “America first” trade policy. Because many of Trump’s priorities can be implemented by executive action, while others are shared by a GOP-controlled Congress, swift action is conceivable in some areas.

Reforming and simplifying the personal and business tax codes could boost growth even before taking into account any reduction in effective tax rates. Improvements in regulatory frameworks could also increase economic dynamism, and cutting taxes, along with deregulation, would likely support the economy. In contrast, a trade agenda emphasizing tariffs or penalties for U.S. multinational firms producing abroad would be a headwind for growth, disrupting supply chains and raising the prices of imported goods. More aggressive immigration enforcement could also have a negative economic impact, creating labor shortages in industries and states with high concentrations of unlawful immigrants, which would raise U.S. wage costs and depress economic growth. Congress may not share Trump’s willingness to risk trade wars, but it is worth noting that under the Trade Act of 1974 the president has the executive authority to withdraw from trade agreements and to impose import tariffs of up to 15% for up to 150 days, without consulting Congress.

GREATER ATTENTION NEEDED FOR TAIL OUTCOMES

The prospects for fiscal stimulus and deregulation, on the one hand, and heightened trade frictions, on the other, have increased the risk of extreme, or “tail,” outcomes for the U.S. economy in 2017. While the political whirlwind of 2016 has not changed our base-case scenario for U.S. growth of roughly 2%, we believe that investors should be prepared for the possibility that growth will be significantly faster or slower—a caution that also applies to the overall global economy.

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